How does One Invest in a Company whose Price will Decline? Part 1
Posted on | June 2, 2010 | 4 Comments
This is not the same question as “Does shorting belong in the value investors’ toolbox,” because shorting is only one way to invest in a company that is expected to decline in share price. But it expresses the idea in an understandable way.
I think the normal response for most value investors to the shorting question is “No.” But is that really true? And if this question is not true then the title question becomes more important to answer in a value investing context. Whitney Tilson of T2 partners and co-founder of the Value Investing Congress uses shorting as a part of his investment tool set. I don’t think anyone would call Tilson a “speculator,” which is the usual label associated with shorting. He uses the value investing techniques of examining the financial statements of companies and setting a value on the company. He currently is shorting a basket of homebuilders. And in his latest letter to investors he discusses his best short position, recently, which is Inter Oil (IOC). The excellent blog Valuehuntr has also taken a short position in the same company. Valuehuntr’s position is based on the premise that IOC may be engaging in fraudulent behavior. If this is true then this could be another company that drops to the floor. Both Tilson and Valuehuntr’s logic and analysis seem sound. But I am still not going to short. Why?
Because I am risk averse. There are aspects of shorting that concern me. First, what is shorting? The idea of shorting is that sometimes it makes sense to take a negative position in a company. Shorting is where you “borrow” the shares of a company from someone else, say your broker, and then you sell the shares in the market. The proceeds are deposited to your account. A profit is made when you buy back the same shares at a lower price and return the shares to the entity that lent them to you.
So what are the risks of Short selling?
The first is the potential for extreme losses. The ordinary potential loss when buying the stock of a company is the amount you invested. If you invest $1000 buying 100 shares of XYZ company. All you can lose is $1000 plus commissions. But when you short a company and the stock price goes up you can keep losing money until you exit the position. It is often referred to as the potential for unlimited losses. It isn’t of course. No company’s stock price continues to rise forever. But the losses can be extreme.
A risk related to this is the risk of margin call. That is when the stock price rises you will be asked to post additional collateral in your account to cover the loses. I never want to be a position for someone else to decide when it is a good time for me to invest more capital into a position. If the price move up is swift you may not have any choice.
The counter argument, of course, is that you can use stops to help prevent just such a scenario. This is true, sort of, but my experience is that stops work poorly in volatile markets like now. If there is an extreme price movement your stop may be triggered but the next price up could we much worse price for you than you would like. Moreover, the stop could be triggered and then the share price retreats, but you have already covered your short and thus you have baked in your loss.
It is clear to me that short selling can play a role in a value investing strategy. After all no one expects every company to always go up. But is shorting the only way? Or are there better alternatives? In the next installment of this I will explore the world of options. While I have not yet fully developed a shorting strategy using options I will discuss some of the possibilities in the second part of this article.
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4 Responses to “How does One Invest in a Company whose Price will Decline? Part 1”
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June 2nd, 2010 @ 11:08 pm
While some value investors like Tilson short stocks, I never felt comfortable with it. The downside is so much larger than the upside. Also people who are running the company are doing everything they can to make the stock price go up. It doesn’t make any sense trying to bet against them. That’s just my two cents.
June 3rd, 2010 @ 8:00 pm
I am not arguing that anyone should use shorting as part of their tool box in value investing, just that it shouldn’t be excluded. I am also not comfortable with shorting for myself. I am more interested in developing a suitable strategy using options.
June 22nd, 2010 @ 12:44 pm
In theory, of course, it’s true that the potential losses when shorting are uncapped — after all, a stock can rise infinitely (in theory), while it can only go down 100%. In practice though, short sellers often manage their risk more conservatively than some long-only value investors.
Pros such as Tim Knight, William O’Neil, and Bart DiLiddo all use fairly tight stops when shorting. So, in practice — although their potential loss on a short position might be “infinite” in theory — in reality, they’re more likely to take a loss of 10% or less on a short that goes against them. On the contrary, some long-only value investors will hold a long position (or continue to add to it) after it drops 50% or more.
I think the bigger reason many investors eschew shorting isn’t so much their perceptions of its risk (though that may be a part of it) as their fear of going against the herd. After all, we all risk 100% losses every time we buy stock, but since almost everyone else is doing it, most investors tend not to dwell on that risk too much. But shorting feels scarier because you’re often standing alone.
Another point to bear in mind is that while shorting alone may be risky, it can be less risky to combine shorting and long investing. A market-neutral portfolio constructed of long positions paired with short positions in the same industries can cancel out most market and industry risk.
And of course another way to limit risk when betting against stocks is to buy puts on them (which I assume you were planning to cover in your next post). Buying puts also gives you the opportunity of generating returns greater than 100%, but it has some additional challenges. E.g., you have to take into account volatility, time decay, spreads (which can be pretty wide on thinly-traded options), etc.
July 10th, 2010 @ 11:34 pm
Thanks for your opinion. Stop orders don’t contain guarantees except that you will sell. Unfortunately, to me, when they are triggered is not always the best time and since no price is guaranteed, in a free fall situation the losses can be substantial before your order is filled. As you suggest the advantage of buying options is that you know what your financial risk is when you purchase the contract.